Download Monetary Policy Implementation during the Crisis in 2007 to

Monetary Policy Implementation during
the Crisis in 2007 to 2008
Since the outbreak of turbulence in the financial markets in August 2007, the implementation
of monetary policy – typically a peripheral aspect for observers of monetary policy – has
attracted increased attention. The heightened attention was accompanied by uncertainty
about how to interpret the liquidity measures taken and what to make of the new instruments
introduced. This contribution provides the facts needed to properly understand central bank
measures by focusing on the euro area and the U.S.A. Essentially, observers need to be aware
that today, the main avenue of monetary policy implementation is interest rates rather than
monetary aggregates such as the monetary base. Moreover, adjusting the liquidity implementation framework is not necessarily tantamount to changing the monetary policy stance.
Finally, the specific institutional frameworks of individual central banks have a bearing on how
they implement monetary policy. The contribution concludes with a description of possible
techniques for implementing monetary policy under very low interest rates.1
Clemens Jobst1
JEL classification: E43, E58
Keywords: monetary policy implementation, financial crisis, operating procedures,
money market, quantitative easing
Since August 2007, the operational
framework for the implementation of
monetary policy, usually a peripheral
aspect of monetary policy, has moved
into the limelight, as central banks have
among others provided large-scale
liquidity injections, introduced new
longer-term refinancing operations
(LTROs), extended the list of assets eli­
gible as collateral for monetary policy
operations, bought mortgage-based
securities and commercial paper, moved
to a fixed rate tender procedure with
full allotment for the main refinancing
operations, and launched new lending
programs. While the monetary policy
stance – which is epitomized by the
policy rate – has always been closely
monitored, observers used to take little
note of the instruments with which
central banks keep market interest rates
closely aligned with official interest
1
2
rates, at least as long as the times were
tranquil. The actual implementation of
monetary policy was considered a technical issue; accordingly, it was often not
well understood.2
Consequently, there was frequent
uncertainty about how to interpret central banks’ measures when the financial
crisis erupted. For instance, do operations providing liquidity on a large scale
signify policy easing? Also, how do the
monetary policy measures of the European Central Bank (ECB) compare
with those of the Federal Reserve System (Fed)? Finally, what does “quantitative easing” mean?
This contribution uses an explanatory overview of the general features of
monetary policy implementation to
provide a better understanding of the
measures taken during the one-and-ahalf years to February 2009. The pre-
[email protected]
This applies even to academic research on monetary policy, which is frequently based on a stylized presentation in
which the monetary base is accorded a key role in the implementation of monetary policy that it does not actually
have in practice. Among other things, such a perspective results in the misconception that reserve requirements
serve to control money supply, or that the central bank steers interest rates by adjusting the monetary base (Borio,
1997, pp. 9–10). Using examples in the literature on liquidity effects, the bank lending channel and sterilized
foreign exchange intervention, Disyatat (2008) demonstrates the problems inherent in models based on monetary
aggregates.
Monetary Policy & the Economy Q1/09
Refereed by:
Ulrich Bindseil, ECB
53
Monetary Policy Implementation during the Crisis in 2007 to 2008
sentation concentrates on the U.S.A.
and the euro area as cases in point, but
the policy of other central banks is easily understood by analogy.
Section 1 sketches out the main elements of monetary policy implementation and delineates some of the major
differences between the approaches of
the ECB and the Fed prior to the onset
of the turmoil in the summer of 2007
as the basis for the interpretation of
their measures after August 2007.
These are then discussed in section 2.
Section 3 deals with the worsening of
the turmoil after the collapse of Lehman
Brothers, the U.S. investment bank, in
mid-September 2008. In retrospect,
central banks were all faced with similar challenges to policy implementation, and, subject to differences in their
operational frameworks, they reacted
similarly to these challenges. The types
of instruments and their use tended to
converge.
Meanwhile, the interest rate cuts in
the wake of the marked deterioration
of the economic outlook since fall 2008
have raised new policy implementation
issues, especially that of how to ease
monetary policy further when interest
rates are already very low. Currently, it
is not clear to what extent individual
central banks will take nonstandard
measures, i.e. measures other than
adjusting interest rates, and what measures these might be. Consequently,
section 4 closes with some general considerations about monetary policy and
policy implementation in a low-interest
rate environment.
1 The Operational Framework
for Implementing Monetary
Policy
Before embarking on the discussion of
monetary policy implementation, it is
3
appropriate to briefly clarify the difference between monetary policy strategy
itself and its implementation.
1.1 Strategic and Operational Targets
As a rule, the tasks of central banks are
laid down in their respective statutes.
For example, the primary objective of
the European System of Central Banks
(ESCB) is “to maintain price stability”;
moreover “without prejudice to the objective of price stability, the ESCB shall
support the general economic policies
in the Community” (Article 105(1) of
the Treaty). The Bank of England Act
1998 also mandates price stability as
the objective of the Bank of England
(BoE), and, subject to that, calls on
the BoE to support growth and employment. The mandate of the Fed is
defined more broadly: In addition to
the requirement of maintaining stable
prices, it calls for monetary policy commensurate with long-run potential
growth, maximum employment and
moderate long-term interest rates.3
Whether a central bank targets low
inflation or full employment, it cannot
control these strategic targets directly;
it can only attempt to reach these
targets through the implementation of
monetary policy measures. Policy implementation is done through an operational target that must comply with two
criteria: First, the operational target
must be such that the central bank is
well equipped to control it, and second, the operational target must have a
predictable causal relationship with
strategic targets, allowing the central
bank to control the strategic target by
controlling the operational target.
There is a broad consensus among
central banks that the best primary target is a very short-term interest rate
For a more detailed presentation of the differences, see e.g. Crespo Cuaresma and Gnan (2008).
54
Monetary Policy & the Economy Q1/09
Monetary Policy Implementation during the Crisis in 2007 to 2008
(Borio, 1997).4 In most cases, this is
the overnight rate – the interest rate at
which banks lend immediately available
funds, namely their deposits or balances with the central bank, to another
bank. While such a very short-term
rate does not play an immediate role for
spending and investment decisions, the
short-term interest rate and expectations about its future course determine
the level of longer term rates, i.e. the
yield curve. Long-term rates in turn
are reflected in decisions taken in the
real economy and thus in the end have
an impact on central banks’ strategic
targets. The process by which changes
in short-term interest rates are passed
on to the economy in general is called
the “monetary policy transmission
mechanism.” Precise steering of shortterm interest rates coupled with a stable transmission mechanism allows
central banks to reach their strategic
targets (ECB, 2004).
1.2 Supply and Demand for Central
Bank Balances, Minimum Reserves, and Short-Term
Interest Rates5
The market for central bank balances
(bank deposits at the central bank),
which determines short-term interest
rates, has some special features. On the
one hand, the central bank is the
monopoly supplier of such balances and
can create these at will. On the other
hand, the central bank has a strong in4
5
fluence on the demand for central bank
balances. This demand results from the
reserve requirements, which the central bank determines, and the prominent role that central banks play in the
payment system. Being able to control
both supply and demand equips central
banks to steer overnight rates very accurately.
For banks, holding balances with
the central bank is a necessity. These
balances are as good as cash, and may
be essential for achieving payment
finality, as in some jurisdictions payments can only be settled with finality
in central bank money. Central bank
money also plays a pivotal role in electronic payment systems that transmit
payments between banks. From a commercial bank’s view, its balances with
the central bank are comparable to cash
in a consumer’s pocketbook: The bank
will try to have balances at a level that
is high enough for it to execute all transactions, even ones that come as a surprise, just like a consumer tries to have
enough cash on hand to buy things on a
whim, if necessary. Like cash, reserves
held at the central bank do not bear interest, or at least not an attractive
amount of interest, however, so that
banks, like consumers, will try to keep
these holdings as small as possible. This
means that demand for balances for
transactions purposes will react very
little to changes in price (in the overnight rate) and is therefore very inter-
An alternative target, previously used by the Fed among others, is the size of bank balances with central banks.
While these aggregates can be easily controlled by central banks as well, this method is subject to constraints, which
eventually prompted the Fed to return to steering the federal funds rate, the rate that banks charge each other for
overnight loans. See Bindseil (2004) on the Fed and Bundesbank, and Tucker (2004) on the Bank of England.
Most central banks have made available detailed descriptions of their operational frameworks. ECB (2004) gives
an introductory overview of the ECB’s framework; the related technical documentation is available in ECB (2008).
Readers interested in policy implementation in the U.S.A. will find easily accessible information in Fed (2005).
Whereas Bank of England (2008) is not targeted at a general readership, it does provide a useful introduction to
the techniques used to control overnight rates that extends beyond the specific situation of the BoE. The fundamental similarities between central banks are more easily discernible in comparative works, however, like those
regularly published by the Bank for International Settlements (BIS). Subsection 1.2 is heavily based on Borio
(1997, 2001). The monograph by Bindseil (2004) includes a detailed, rather advanced-level discussion and in
addition provides a description of the evolution of policy instruments over time.
Monetary Policy & the Economy Q1/09
55
Monetary Policy Implementation during the Crisis in 2007 to 2008
Chart 1
Demand for Central Bank Balances
Market for Reserve Balances
without Reserve Requirements
Market for Reserve Balances
with Reserve Requirements
Overnight rate
Overnight rate
r?
Demand
Supply
Demand
re
Supply
R*
R*
Central bank reserves
est-inelastic, as evidenced by the vertical curve of the demand function in
Chart 1 (left panel): Demand for the
transaction balance, or reserves, R is
independent of, or hardly dependent
on, interest rate r. Without intervention by the central bank, even tiny fluctuations in demand for balances would
lead to very strong interest rate fluctuations, given fixed supply (with the
central bank as the monopoly supplier).
If the demand of all banks exceeds the
supply of central bank money, the interest rate rises very sharply, as banks
are hardly willing to forgo the reserves
that they urgently need even if interest
rates are high. Conversely, if demand is
only slightly lower than central bank
supply, many banks will try to shed
excess balances, but will not find any
takers: the price (interest rate) declines
toward zero.
The best way to understand the supply of central bank balances is to study
the central bank’s balance sheet. For
easier reading, the items in the balance
sheet can be rearranged under four categories:
56
–
R
Central bank reserves
1. Autonomous factors cover all balance sheet items other than those
linked with monetary policy operations and central bank balances.
Typically, these factors are not under the direct control of the central
bank, or, at least, they are not managed within the operational framework of implementing monetary
policy. The autonomous factors include banknotes in circulation, general government deposits and the
long-term investments of the central bank, and they are found both
on the liability side (e.g. banknotes
in circulation) and on the asset side
(e.g. gold holdings). In monetary
policy implementation practice, the
autonomous factors are considered a
given.
2. Open market operations are part of
a central bank’s operational framework. They are conducted on initiative of the central bank with the objective of managing the volume of
central bank balances. In open market transactions, the central bank
can, e.g., sell or buy assets outright
or conclude repurchase agreements
Monetary Policy & the Economy Q1/09
Monetary Policy Implementation during the Crisis in 2007 to 2008
(repos). Under such repos, the central bank buys (sells) securities and
simultaneously obtains the right and
obligation to resell (repurchase)
them at a future date. Whenever
open market transactions are conducted, central bank balances are
either created or destroyed.
3. Standing facilities are also monetary
policy operations, but they are conducted on initiative of banks, unlike
in the case of open market operations. The central bank determines
the conditions applicable to the
standing facilities, whereas the degree of utilization is determined by
the eligible counterparties. By way
of example, in the euro area there is
a liquidity-absorbing deposit facility
under which banks can make overnight deposits, and there is a marginal lending facility under which
banks can obtain additional liquidity overnight against collateral.
4. Current account holdings with the
central bank.
From the central bank’s perspective,
current account holdings with the central bank represent the balance of the
three above-mentioned components.
Assuming that the autonomous factors
are exogenous, the objective of mone-
tary policy implementation is to wield
open market operations and the standing facilities such that the supply of deposits and banks’ demand for deposits
is in equilibrium at the desired interest
rate (chart 1).
As mentioned, the demand for central bank money for transaction purposes is rather interest-inelastic. As a
result, the central bank is faced with
fairly large interest rate fluctuations.
Various technical solutions to this problem are available: Many central banks,
including e.g. the ECB and the Fed, operate a minimum reserve system based
on averaging provisions.6 The idea is to
give banks a second motivation for
holding central bank balances above
and beyond the transaction motive: this
type of holding reacts more elastically
to the interest rate and thus prevents
overly large interest rate fluctuations.
The reserve requirement in the euro
area is such that banks have to hold
minimum reserves in excess of the
amounts they need for transaction purposes (chart 1, right panel: reserves for
transaction purpuses R*< average re– ) – but they do not
serve requirement R
need to do so every single day: compliance with reserve requirements is determined on the basis of the average
Chart 2
Stylized Central Bank Balance Sheet
Assets
Gold, foreign exchange
Investments
Liabilities
Capital and reserves
General government balances
Banknotes in circulation
Securities purchased under open market transactions
Liquidity-providing repurchase agreements
Lending facility
Total assets =
Liquidity-absorbing repurchase transactions
Deposit facility
Bank balances
Total liabilities
Central bank balances
Autonomous factors
Monetary policy operations
6
Canada and Australia, e.g., have systems that do not use minimum reserves (Borio, 1997).
Monetary Policy & the Economy Q1/09
57
Monetary Policy Implementation during the Crisis in 2007 to 2008
daily balances on the counterparties’
accounts over the course of the maintenance period. As long as banks expect
the interest rate to be unchanged over
this period, it is not important when
they hold the required reserves – today,
tomorrow or in a week – as long as they
hold at least the amount needed for
transactions R* every day. Averaging
substantially increases demand elasticity: If the interest rate is only marginally higher than the expected future
rate re, many banks will be willing to
lend out their reserves in the expectation that they will be able to comply
with the reserve requirement later in
the period at lower interest. The reverse applies when the interest rate falls
short of the expected future rate re. In
fact, demand is perfectly elastic for the
interest rate expected for the remainder of the period (chart 1, right panel).
Hence, averaging periods act as a
buffer. Thus, for central banks, supply
management focuses on the last day of
the minimum reserve maintenance period when banks have to boost holdings
to reach the average or, alternatively,
invest balances held in excess of the average. On this day, the market is once
again in the same position as in chart 1
(left panel). Under these conditions,
the ECB conducts fine-tuning operations that either provide or withdraw
liquidity as needed. In the U.S.A., the
reserve requirements are substantially
lower than in the euro area, and the
averaging period is shorter. The principle,
though, is the same in both systems.7
7
8
1.3 Provision of Central Bank Money
in the Euro Area and in the U.S.A.
up to the Summer of 2007
The bulk of central bank money used to
be supplied through open market operations in the euro area and in the
U.S.A. The Fed resorted primarily to
direct purchases and sales of securities
and used repos mainly for fine-tuning,
e.g. to offset seasonal fluctuations in
currency in circulation. The ECB used
repos both for structural liquidity-providing operations and to meet peak
demand.8 Essentially, the maturities
and frequencies of open market operations are set depending on how often a
central bank wants to hold auctions and
on how extensively it uses open market
operations to manage liquidity. The
Fed’s approach was to manage central
bank balances through daily operations.
Thanks to high reserve requirements
and the averaging period, the ECB got
by on weekly operations plus the abovementioned fine-tuning operations at
the end of the maintenance period; in
addition, three-month repos covered
part of the structural liquidity need.
Central banks tend to use standing
facilities to absorb shocks, e.g. end-ofday and end-of-period shocks when
banks have a shortfall of liquidity or excess liquidity. As banks have unlimited
access to standing facilities at all times,
these instruments prevent market interest rates from fluctuating excessively. In the euro area, the overnight
rate cannot rise above the rate on the
lending facility (usually the official rate
The BoE applies an interesting variant of the minimum reserve regime: Based on banks’ predictions of how volatile
their demand for reserves will be, banks themselves determine the amount of minimum reserves prior to the
beginning of the maintenance period. The BoE provides interest on reserve holdings if they are close to the reserve
target. No interest is paid on excess reserves, and if reserve holdings are below target, the respective bank must pay
interest (details in Clews, 2005; for a more basis discussion, see Tucker, 2004).
There are arguments supporting both variants: Direct purchases prevent regular auctions of large volumes of
funds. On the other hand, repos should have less of an influence on relative prices; moreover, no decision is
required on securities to be purchased.
58
Monetary Policy & the Economy Q1/09
Monetary Policy Implementation during the Crisis in 2007 to 2008
+100 basis points); at the same time,
the interest on the deposit facility (official rate – 100 basis points) prevents
the overnight rate from falling too
far. In line with their role among the
different liquidity-providing operations, standing facilities generally have
a maturity of no more than one day. In
the U.S.A. reserves were not remunerated until the financial crisis intensified
in 2008; the purpose of switching to
remuneration was to create a lower
limit for the overnight rate along the
lines of the ECB deposit facility.
Chart 3 shows the main balance
sheet components of the Eurosystem
and of the Fed. Given the Fed’s heavy
reliance on outright purchases of U.S.
Treasury securities, such securities predominate on the asset side of its balance
sheet. In contrast, the volume of repo
operations was insignificant, and the
credit facility (discount window) was
hardly accessed. Banknotes accounted
for the lion’s share of liabilities, whereas
banks’ holdings on current accounts
with the Fed were fairly small.
Unlike the Fed, the ECB resorted
heavily to repos for its monetary policy
operations, whereas volumes under the
credit and deposit facilities were insignificant. Banknotes (liabilities) and
foreign exchange (assets) predominated
among the autonomous factors. Corresponding to the Eurosystem’s higher
reserve requirements, banks’ balances
on current accounts with the Eurosystem accounted for a larger share of the
balance sheet than in the case of the
Fed.
Up to the summer of 2007, both
the Eurosystem and the Fed controlled
only the overall amount of liquidity
available to the banking sector whereas
the interbank market was responsible
for the intermediation of funds from
banks participating in the central
bank’s monetary policy operations to
other banks as well as from banks with
excess liquidity to those with a need
for liquidity.
Different ranges of counterparties
were eligible to participate in monetary
policy operations with the ECB and
Chart 3
Consolidated Balance Sheet of the Fed and the Eurosystem (at the end of 2006)
Fed
Eurosystem
USD billion
EUR billion
Assets
Gold, foreign currency
33.7
Float
3.5
Other assets
11.8
U.S. Treasury securities 783.6
Repurchase agreements 40.8
Liabilities
Capital, other liabilities
Government balances
Banknotes
Bank balances
Discount window
0.0
873.4
67.0
4.7
783.0
Assets
Gold, foreign currency
Other assets
319.0
380.5
Long-term repurchase agreements
Short-term repurchase agreements
120.0
330.5
18.7
873.4
Lending facility
0.0
1,150.0
Liabilities
Other liabilities
Capital
Banknotes
282.0
66.2
628.2
Deposit facility
Bank balances
0.1
173.5
1,150.0
Central bank balances
Autonomous factors
Monetary policy operations
Sources: Annual reports of the Fed and the ECB.
Monetary Policy & the Economy Q1/09
59
Monetary Policy Implementation during the Crisis in 2007 to 2008
with the Fed. In the euro area, in principle all institutions subject to reserve
requirements were eligible to participate in open market operations and had
access to the standing facilities. While
all banks subject to reserve requirements were able to refinance themselves at the discount window in the
U.S.A., the Fed conducted the regular
open market operations only with 20
investment banks, the primary dealers,
most of which in turn had no access to
the discount window.
A similar distinction between open
market operations and standing facilities was made with regard to the eligible securities. As a rule, central banks
require counterparties to collateralize
all credit transactions with them using
e.g. government securities (Chailloux
et al., 2008b; ECB, 2007). In defining
which securities are eligible as collateral for regular repurchase agreements,
the Fed was very restrictive and admitted only securities issued or guaranteed
by the government or another public
sector entity. By contrast, the list of
securities admitted to the discount
window was very long. Along the lines
of its treatment of counterparties, the
ECB did not apply different eligibility
criteria to regular operations and to
standing facilities. The eligibility criteria for collateral were broad for both
types of operations.
2 Changes since the Summer of 2007
To sum up, before the summer of 2007,
monetary policy instruments and operational frameworks in the industrialized countries of the West displayed
important common features, but there
were also some key differences: The
9
large majority of central banks, including the ECB and the Fed, used a very
short-term rate in implementing their
monetary policy. In both institutions,
the implementation and the transmission of monetary policy impulses relied
significantly on well-functioning money
and capital markets. There were differences, however, in the composition of
the balance sheet, the range of counterparties eligible for monetary policy operations, the eligible securities and the
design of the individual monetary policy instruments. As long as the financial markets operated smoothly, these
differences were largely irrelevant,
though.
All this changed very rapidly when
the tensions that had started in the
U.S. mortgage lending markets in the
spring of 2007 spread to the money
markets at the beginning of August
2007. Concerns about the risks attached to subprime mortgage loans led
to price losses of subprime-backed securities that quickly cascaded through
to other risk-fraught segments of the
securities market. Uncertainty about
the extent and distribution of losses
prompted investors to withdraw to
safe-haven investment. When it became
known at the end of July 2007 that IKB
Deutsche Industriebank AG had sustained huge losses, the crisis spread to
Europe as well. Concern about sudden
liquidity needs caused banks’ demand
for funds to rise sharply, and the overnight rate surged to levels far above the
official rate. The volume of funds traded
declined, and there were signs of
rationing. On August 9, 2007, the ECB
took the first measures to enhance
liquidity; the Fed and other central
banks soon followed.9
Borio (2008) provides a synoptic account of the years preceding the crisis. For a chronology of the summer months
of 2007, see BIS (2007) and the OeNB’s Financial Stability Reports 14 and 15.
60
Monetary Policy & the Economy Q1/09
Monetary Policy Implementation during the Crisis in 2007 to 2008
2.1 Tensions in Various Financial
Market Segments Have Weakened Monetary Policy
Transmission Channels
The key role of liquidity in banking results from the particular role banks play
in modern economies.10 The structural
discrepancy between short-term borrowing and long-term lending puts
banks at the risk of bank runs.11 While
current and savings account deposits by
nonbanks are frequently secured by deposit insurance, the risk of a run is also
given in the unsecured segment of the
money market, which has become increasingly important in recent years
(Borio, 2007). Expectations play a major role, also in the banks’ management
of their own liquidity: If banks, for instance, anticipate difficulties in accessing short-term funding in the interbank
market, they will hoard excess funds
themselves and will extend less credit
to other banks. Like a run, liquidity
hoarding turns into a self-fulfilling
prophecy and causes liquidity to dry
up, even if concerns about other banks’
solvency and creditworthiness are unfounded. Central banks consider a liquidity shortage in interbank markets a
problem not just because they are specifically responsible for banking and financial stability, but also because a
shortage represents a challenge to the
stability of the short-term market rate
and thus monetary policy implementation.12
In the summer of 2007, the first
immediate challenge for central banks
was to control the overnight rate. Controlling the short-term rate in an oper-
ational framework like the ECB’s is
based on stable expectations about the
development of short-term rates over
the reserve maintenance period and on
the smooth distribution of liquidity
among banks via the interbank market.
When the crisis broke out, unstable demand for reserves caused short-term
rates to fluctuate, which in turn reduced banks’ willingness to lend
money. Consequently, the overnight
rate – the starting point of the monetary policy transmission mechanism –
could no longer be kept in line with the
official rate as envisaged (chart 4).
The turbulences had an impact not
just on the overnight rate. Banks’ worries about their future funding stress
boosted their demand for longer-term
funding in the interbank markets substantially, which caused the spread of
three-month interest rates over expected overnight rates to shoot up
(chart 5). This was compounded by
concerns about counterparties’ creditworthiness.13 The turmoil in long-term
money and foreign exchange markets
did not directly hamper the management of the overnight rate, but did affect the transmission from the policy
rate through money market rates to the
rates relevant for the real economy
(IMF, 2008). Therefore, central banks
took measures to calm these markets as
well.
Additionally, the issue arose of how
to adjust monetary policy in reaction to
the effects of the financial turmoil on
the real economy. This question, however, lies outside the scope of this contribution.
10 For an overview of the following issues, see e.g. Freixas and Rochet (1997).
Due to asymmetric information, loans extended by banks are hard to sell or only at a significant discount. Even if
a bank could have covered all liabilities originally, illiquidity may turn into insolvency under such circumstances.
12 Historically, monetary policy as practiced today is a recent central banking task. Liquidity management and the
lender-of-last-resort role may thus be viewed as the original functions of central banks. See e.g. Goodhart
(1988).
13 Distinguishing between credit and liquidity risk is difficult empirically; see Michaud and Upper (2008).
11 Monetary Policy & the Economy Q1/09
61
Monetary Policy Implementation during the Crisis in 2007 to 2008
Chart 4
Overnight Rates and Policy Rates until September 2008
%
7
6
5
4
3
2
1
0
Jan. 07
Apr. 07
July 07
Oct. 07
ECB rate in main refinancing operations
Federal funds target rate
U.K. bank rate
Jan. 08
Apr. 08
July 08
Euro area overnight rate (EONIA)
Effective federal funds rate
U.K. overnight rate (SONIA)
Sources: Thomson Reuters, NCBs.
Chart 5
Spread between Three-Month Collateralized and
Uncollateralized Interbank Loans1
basis points
400
350
300
250
200
150
100
50
0
Jan. 07
Apr. 07
USD
July 07
EUR
Oct. 07
Jan. 08
Apr. 08
July 08
Oct. 08
Jan. 09
GBP
Source: Thomson Reuters.
1
In the markets for collateralized loans, borrowers provide collateral for funds, usually liquid securities, that the lender may sell upon maturity if the
borrower fails to repay the loan.
2.2 Measures to Facilitate Banks’
Liquidity Management14
In principle, monetary policy instruments are designed to ensure a stable
supply of liquidity. In the summer of
2007, central banks expanded the set
of monetary policy instruments and
adjusted it to facilitate banks’ liquidity
management even further.15 Four of the
dimensions of the policy framework
14 The ECB’s Monthly Bulletin contains a chronology of the most recent monetary policy measures. A dedicated
website of the Fed provides insights into the Fed’s new instruments and programs (http://www.federalreserve.
gov/monetarypolicy/bst.htm).
15 These measures are aimed at all banks eligible to participate in central banks operations. This study does not
cover liquidity aid for individual banks (Emergency Liquidity Assistance – ELA – in the euro area).
62
Monetary Policy & the Economy Q1/09
Monetary Policy Implementation during the Crisis in 2007 to 2008
discussed above are especially relevant
to liquidity management (Bindseil,
2009):
1. Availability of securities eligible as
collateral for monetary policy operations. The supply of liquidity is
more stable if (1) many different
types of securities are eligible, (2) a
far larger volume of securities is
available than is actually used for
central bank operations, and (3) these
securities are distributed evenly in
the banking system.
2. Credit facility: The credit facility is
used on individual banks’ initiative;
it thus provides practically guaranteed access to central bank liquidity.
3. Broad access to central bank operations: In the case of liquidity constraints triggered by distrust among
banks, direct access to the central
bank provides an alternative distribution mechanism.
4. Reserve averaging allows strong
fluctuations in individual bank’s
daily balances in the short-term,
thus helping to absorb liquidity
shocks.
In all monetary areas, the central banks’
measures followed a similar objective,
namely to facilitate liquidity management. However, this objective was
implemented in different ways that
were contingent on the operational
framework in place before the turmoil.
A simple measure employed to give
banks more certainty that they would
be allocated sufficient liquidity was to
conduct more operations with larger
volumes. To alleviate the uncertainties
at the end of 2007, the ECB provided
unlimited liquidity at the turn of the
year for two weeks but then conducted
16 offsetting transactions to reabsorb the
liquidity right away. The rationale was
to provide every bank individually with
sufficient liquidity while preventing excess liquidity that could have exerted
pressure on the overnight rate.
In systems with high minimum reserve requirements subject to averaging
provisions such as those of the ECB and
the Swiss National Bank (SNB), banks
could by construction let their daily
balances fluctuate sharply. However, as
banks were uncertain whether they
would have continued access to sufficient liquidity, they had a strong interest in fulfilling their reserve requirements early in the period, which – given
that the total supply of central bank
liquidity is fixed – not all banks would
have been able to do at the same time.
Therefore, the ECB and the SNB increased liquidity allocation at the
beginning of the period and reduced it
by the same measure at the end of the
period, a practice referred to as frontloading (chart 6).16
At the same time, the central banks
had to ensure that liquidity was distributed properly among banks – i.e. that
the intermediation of funds within the
banking system, which normally occurs through the interbank market, did
indeed work properly. A first option
that circumvented the dysfunctional interbank market was to widen the range
of banks admitted directly to central
bank operations. The Fed in particular
chose this tack. Traditionally, only a
handful of banks were admitted to open
market operations with the Fed; the establishment of the Term Auction Facility (TAF) created a similar instrument
for a very large group of banks. In exchange, the primary dealers – previ-
The BoE, with its system in which banks choose their reserve targets and pay penalty interest for overshooting or
undershooting their own target, reached a similar result by permitting significantly larger deviations around the
reserve target.
Monetary Policy & the Economy Q1/09
63
Monetary Policy Implementation during the Crisis in 2007 to 2008
Chart 6
Minimum Reserve Requirements and Fulfillment
EUR billion
450
400
350
300
250
200
150
100
50
0
Jan. 07
Apr. 07
Maintenance period
July 07
Oct. 07
Jan. 08
Reserve requirement
Apr. 08
July 08
Oct. 08
Jan. 09
Reserve holdings excluding deposit facility
Source: ECB.
ously eligible to participate only in open
market operations – were given access
to a credit facility, the Primary Dealers
Credit Facility (PDCF).
A second option to facilitate access
to central bank liquidity for banks was
to expand the list of securities eligible
for monetary policy operations. Furthermore, new facilities of the BoE –
the Special Liquidity Scheme (SLS) –
and the Fed – the Term Securities
Lending Facility (TSLF) – allowed
banks to swap previously ineligible securities, e.g. corporate bonds, against
government securities (Fleming et al.,
2009). The government securities acquired under these programs were then
available either for private transactions,
e.g. as collateral for interbank lending,
or for operations with the central bank.
Conversely, the ECB widened neither the range of eligible counterparties nor did it fundamentally change the
list of eligible securities,17 given its precrisis open system of counterparties
17 and comprehensive list of eligible securities. Thereby banks’ new needs could
be met within the existing framework.
By construction, credit facilities
represent further reassurance for banks
that they would, ultimately, receive
liquidity directly from the central
banks. As a rule, the premium that
banks pay on the credit facility compared to the main refinancing operation is, however, designed to restrict
the use of the credit facility to exceptional situations. To make the credit facility more attractive for banks, the Fed
therefore gradually reduced this premium in response to the financial crisis. Yet both in the U.S.A. and in the
U.K., recourse to the credit facility
was taken as a signal that a bank was in
distress. This stigma alienated banks
that merely had a temporary liquidity
management problem, such as a large
end-of-day payment, and prevented
them from using the facility. With this
experience in mind, the BoE reformed
The ECB expanded the list of securities at the end of October 2008, but tightened the criteria for specific categories of asset-backed securities and uncovered bank bonds in January 2009.
64
Monetary Policy & the Economy Q1/09
Monetary Policy Implementation during the Crisis in 2007 to 2008
the credit facility from the ground up
(Bank of England, 2008). The euro
area did not suffer from this stigma; the
credit facility fulfilled the function
assigned to it.
2.3 Measures to Support the Term Money Markets and
Foreign Exchange Markets
As indicated previously, the banks’
liquidity concerns produced tensions
also in the longer-term money markets.
While monetary policy implementation
does not target these markets directly,
they do play an important role in monetary policy transmission.
Indirectly, the term markets received support from the stabilization of
overnight markets already. If banks are
certain that they will receive overnight
liquidity any time at acceptable terms,
their willingness to lend excess liquidity for longer periods grows. However,
overall, the crisis caused demand for
long-term liquidity to rise in 2007 by
relation to the supply available. Consequently, central banks provided
relatively higher volumes of funds in
long-term operations. The ECB acted
first among central banks and started as
early as August 2007 to reduce the volumes in the weekly refinancing operations and at the same time to increase
the funds provided in three-month
LTROs. Moreover, it offered an LTRO
with a maturity of six months. Other
central banks had to create longer-term
refinancing operations from scratch,
e.g. the SNB. The BoE also boosted the
share of longer-term operations among
its liquidity-providing operations. 18
18 The constraints in the interbank
market were not limited to a single
monetary area, but also affected foreign
exchange markets (Baba et al., 2008).
European banks found it especially difficult to obtain U.S. dollar funding. In
December 2007, reciprocal swap agreements (swap lines) between the Fed and
the ECB, BoE and SNB, respectively,
were concluded to provide European
banks with U.S. dollar funding through
their central bank. When the turmoil
became stronger in September 2008,
the tenders were expanded considerably.
2.4 Assessment of the Impact of
Liquidity Management Measures
on Central Banks’ Balance
Sheets
At first glance, the expansion of funding under the existing facilities and the
introduction of additional tenders and
facilities appeared to create additional
liquidity. Formulations such as “central
banks flood the market with liquidity”
suggested that central banks had expanded the volume of their operations
sharply. In actual fact, the size of the
large central banks’ balance sheets remained unchanged – what did change
was the composition of the balance
sheets.
For example, as chart 7 shows, the
Fed sold U.S. Treasury securities to the
same extent as repo operations were
extended and new facilities, such as the
TAF, were introduced. The chart
clearly indicates the operations conducted before the change of the year
2007 to 2008 and the bailout of the
In the case of the Fed, these arrangements were complemented by special programs for specific markets, such as the
Term Securities Lending Facility for collateralized money markets, the Asset-Backed Commercial Paper Money
Market Mutual Fund Liquidity Facility and the Commercial Paper Funding Facility for the commercial paper
market, and the Term Asset-Backed Securities Loan Facility for particular segments of the market for collate­
ralized loans. For details on the individual programs and further literature, see in particular http://www.federal­
reserve.gov/monetarypolicy/bst.htm
Monetary Policy & the Economy Q1/09
65
Monetary Policy Implementation during the Crisis in 2007 to 2008
Chart 7
Consolidated Balance Sheet of the Fed – Assets
USD billion
2,500
2,000
1,500
1,000
500
0
July 07
Oct. 07
Jan. 08
Apr. 08
July 08
Oct. 08
Jan. 09
U.S. Treasury securities
Federal agency debt securities
Repurchase agreements
Term Auction Facility
Primary dealer and other broker-dealer credit
Measures to support AIG and Bear Stearns
Other assets including gold
U.S. Treasury securities lent to primary dealers
Mortgage-backed securities
Credit facilities (primary, secondary und seasonal credit)
Commercial paper funding facility
Asset-backed commercial paper funding facility
Central bank liquidity swaps (dollar value)
Source: Fed.
Chart 8
Consolidated Balance Sheet of the Eurosystem – Assets
EUR billion
2,500
2,000
1,500
1,000
500
0
Jan. 07
Apr. 07
July 07
Gold
Other assets
Main refinancing operations
Credit facility
Oct. 07
Jan. 08
Apr. 08
July 08
Oct. 08
Jan. 09
Claims on non-euro area residents denominated in foreign currency
Longer-term refinancing operations
Fine-tuning reverse operations
Claims on euro area residents denominated in foreign currency
Source: ECB.
U.S. investment bank Bear Stearns in
spring 2008. Moreover, the Fed lent a
growing share of government securities
against less liquid eligible collateral to
improve primary dealer’s balance
sheets. On balance, this adjustment did
not have an effect on banks’ reserve
holdings with the Fed, nor did it have
an effect on the Fed’s total assets.
The expansion of longer-term repos
of the BoE, the SNB and the ECB was
offset by a reduction of the same size in
66
short-term repos. Chart 8 shows this
shift for the balance sheet of the Eurosystem. The outbreak of the turmoil in
summer 2007 did not affect the longterm growth trend of the balance sheet
that is driven above all by rising demand
for currency in circulation. The balance sheet also shows the temporary
operations conducted around the turn
of the year. Central banks that expanded the list of eligible securities or
that accepted more risky securities
Monetary Policy & the Economy Q1/09
Monetary Policy Implementation during the Crisis in 2007 to 2008
from banks were subject to higher risk;
the total size of their balance sheets
rose only minimally until fall 2008.19
3 Measures Taken after the
Bankruptcy of Lehman Brothers
When Lehman Brothers, one of the
major U.S. investment banks, filed for
bankruptcy protection in September
2008, the financial crisis took a dramatic turn for the worse. As an issuer
of short-term instruments bought by
money market funds, of credit default
swaps and as a broker, Lehman Brothers
held a key position in important segments of the financial market. The
threat that a systemically pivotal bank
might not be able to fulfill its obligations weighed heavily on the interbank
market. The total volume of trading in
the interbank market declined, and
banks became very concerned about
refinancing. Massive outflows from
money market funds unleashed a torrent of sales that extended to all but the
safest types of investment. The turmoil
spread to other banks, triggering a series of increasingly broader government
support packages. From mid-October
2008, the financial markets were buffeted by growing concern about the
course of the real economy. Central
banks responded with liquidity measures and interest rate cuts (BIS,
2008).
3.1 New Measures
Up until then, the central banks’ liqui­
dity measures had supported the interbank market but had depended on a
more or less proper functioning of that
19 market. Under the prevailing conditions, however, this strategy no longer
worked. When Lehman Brothers filed
for bankruptcy, banks lost all remaining confidence in other market participants, as the jump in risk premiums on
uncollateralized loans depicted in chart
5 shows. Many banks with excess liquidity on their hands were no longer
willing to lend to other banks with
temporary liquidity needs, not even
overnight, and the interbank market all
but broke down. The option of choice
for central banks was to take over the
intermediation function.
This strategy was most clearly observable at the ECB. At weekly tenders,
the Eurosystem’s main refinancing operations, banks previously had to bid
for a fixed amount of liquidity determined by the ECB. Although this volume was raised when the ECB frontloaded liquidity allocation to the beginning of the maintenance period, banks
remained uncertain whether liquidity
would be allotted to them and whether
enough liquidity would be available in
the interbank market. This uncertainty
led to a rise in average bids in the course
of September 2008. On October 8,
2008, the weekly main refinancing
procedure was held with full allotment
at a fixed interest rate, the interest rate
on the main refinancing operation. This
removed any vestiges of uncertainty
about liquidity management for banks.
Chart 8 shows the rise in the allotment
amount in the main and longer-term
refinancing operations.
The Fed provided banks and primary dealers with liquidity under the
credit facility, the discount window
The BoE with its reserve targets set by banks represents an outlier. In the U.S.A. and in the euro area, minimum
reserves are calculated on the basis of banks’ balance sheets. As excess reserves attract no interest or only low interest, banks had little incentive to hold excess reserves, so that the liability side of the central banks’ balance sheets
remained unchanged. As banks in the U.K. can determine their reserve targets themselves, and as these reserves
attract interest, the uncertainty after the summer of 2007 prompted banks to increase their reserve targets, expanding the BoE’s balance sheet.
Monetary Policy & the Economy Q1/09
67
Monetary Policy Implementation during the Crisis in 2007 to 2008
and new programs such as the AssetBacked Commercial Paper Money Market Mutual Fund Liquidity Facility and
in conjunction with the government
rescue package for the insurance company AIG. Chart 7 also clearly indicates
the increase in allotment under the
TAF and purchases of commercial
paper. In February 2009, the Fed began
to acquire mortgage-based securities.
Internationally coordinated measures were taken to supplement the individual central banks’ measures. Apart
from the joint interest rate move on
October 8, 2008, which was aimed at
strengthening confidence in the monetary policymakers’ ability to act, these
measures included efforts to prevent
international liquidity bottlenecks. Intercentral bank swap lines were extended, and on October 13, 2008, the
Fed, the ECB, the BoE and the SNB
announced that they would conduct
tenders of U.S. dollar funding at fixed
interest rates for full allotment, just
like the tenders of the ECB.20 The financial statements of the Fed and the
Eurosystem (charts 7 and 8) reflect the
balances from the swap operations and
U.S. dollar auctions.
3.2 Pressure on Overnight Rates and Liquidity Absorption
Purchases of securities without reductions of other portfolio items and the
substantially higher allotments in repo
operations resulted in a considerable
increase in the size of the major central
banks’ balance sheets. In the euro area
and in Switzerland, balance sheets expanded by some 30%; the Fed’s and the
BoE’s balance sheet volume doubled.
These increases occurred in just a few
short weeks, and, while they are certainly evidence of the central banks’
decisive action, they are not in themselves a measure of individual currency
areas’ problems or of central banks’ activities. The rates of balance sheet
growth are contingent not just on the
needs of the banking sector, but also on
the size of balance sheets before the crisis and on the degree to which government bailout packages were handled
through central bank balance sheets.
In any event, a rise on the asset side
is inevitably linked to a rise on the liability side. A look at the stylized central
bank balance sheet in chart 9 shows
that, given constant autonomous factors unchanged by the worsening of the
Chart 9
Impact of an Increase in the Asset Side of a Central Bank’s Balance Sheet
Assets
Gold, foreign currency
Investments
Liabilities
Capital and reserves
Government balances
Banknotes in circulation
Bank balances
➧
➧
Bank balances
Total liabilities
Total assets =
Liabilities
Capital and reserves
Government balances
Banknotes in circulation
Liquidity-providing operations
Liquidity-providing operations
Total assets =
Assets
Gold, foreign currency
Investments
Total liabilities
Central bank balances
Autonomous factors
Monetary policy operations
20 At the regional level, similar arrangements were agreed for the euro and the Swiss franc. See box 3 in BIS
(2008).
68
Monetary Policy & the Economy Q1/09
Monetary Policy Implementation during the Crisis in 2007 to 2008
crisis, the additional liquidity had to increase bank deposits at the central
bank. As explained in section 1, though,
demand for central bank balances is interest-inelastic; the excess supply of
central bank balances relative to the
amount needed to fulfill reserve requirements exercises strong downward
pressure on the overnight rate. In extreme cases, the overnight rate drops
to zero.21 To keep market rates at the
level of key interest rates, excess liquidity had to be absorbed.
Faced with the same task, the ECB,
the Fed and the BoE chose different approaches befitting their respective operational frameworks. In the case of the
Eurosystem, the expansion of the balance sheet was limited; moreover, the
Eurosystem’s operational framework
facilitated the automatic absorption of
excess liquidity through the deposit facility. As the deposit facility gives banks
the option of investing any given
amount at fixed interest at the end of
the day, the market rate cannot fall
below the interest rate on the deposit
facility. In recent years, the interest
rate on the deposit facility has always
been 1 percentage point below the key
interest rate. At the utmost, excess liquidity would have caused the market
rate to sink to a level 1 percentage point
below the key interest rate. To hold the
market rate closer to the key interest
rate, the ECB reduced the corridor between the rate on the marginal lending
facility and the rate on the deposit facility to ±½ percentage point around the
rate on the main refinancing operation
on October 8, 2008. As chart 10 evidences, apart from a marginal rise in
currency in circulation, the liquidity
not required to fulfill reserve requirements subsequently went into deposit
holdings. To sum up, the ECB strengthened its intermediation role to offset
the interbank market from seizing up:
It accepted deposits of banks with excess liquidity on one side and provided
banks in need of liquidity with funds
against collateral on the other side.
Before the crisis, the Fed did not
have an instrument that corresponded
to the ECB’s deposit facility. Banks’ deposits with the Fed were not conceived
Chart 10
Consolidated Balance Sheet of the Eurosystem – Liabilities
EUR billion
2,500
2,000
1,500
1,000
500
0
Jan. 07
Apr. 07
July 07
Capital and reserves
Other liabilities
Current accounts
Other liquidity-absorbing operations
Oct. 07
Jan. 08
Apr. 08
July 08
Oct. 08
Jan. 09
Revaluation accounts
Banknotes in circulation
Deposit facility
Liabilities to non-euro area residents denominated in euro
Source: ECB.
21 Depending on the distribution of reserves among banks and the assessment of risk for each bank, rationing can
lead to a positive interest rate in equilibrium.
Monetary Policy & the Economy Q1/09
69
Monetary Policy Implementation during the Crisis in 2007 to 2008
Chart 11
Consolidated Balance Sheet of the Fed – Liabilities
USD billion
2,500
2,000
1,500
1,000
500
0
July 07
Oct. 07
Currency in circulation
Repurchase agreements
Bank balances
Jan. 08
Apr. 08
July 08
Oct. 08
Jan. 09
Other liabilities including capital
Other balances
U.S. Treasury supplementary financing account
Source: Fed.
to bear interest.22 Therefore, an automatic lower limit on the short-term interest rate did not exist. Consequently,
the Fed took two measures. To absorb
liquidity, the U.S. Treasury issued
Treasury bills of more than USD 500
billion and deposited the proceeds with
the Fed (see the Treasury Supplementary Financing Account in chart 11). At
the same time, the remuneration of reserves, scheduled for introduction in
2011, was brought forward, creating a
mechanism similar to that of the
ECB’s deposit facility.23 Consequently,
the federal funds rate did not fall to
zero even though banks had high excess
funds, as shown in chart 11.
Central banks can also issue interest-bearing securities to absorb liquidity, an option chosen by the BoE,
Sveriges Riksbank and the SNB, among
others.24
To sum it up, the central banks adjusted their policies in similar ways,
though their approaches were informed
by the differences in the respective operational frameworks. The interbank
markets seized up almost completely in
nearly all monetary areas. In response,
central banks increased their balance
sheets on the asset side. Central banks
had to absorb the excess liquidity thus
created so as not to lose control of the
market interest rate. To this end, central banks wielded a mix of instruments
comprising open market operations and
interest-bearing facilities. Whereas the
various measures stopped short-term
rates from sinking below a certain level,
they were not completely successful.
22 This was possible because the reserve requirements are very low by comparison to those in the euro area and the
implicit tax resulting from the fact that these deposits did not bear interest was therefore negligible.
23 At the outset, the Fed set the interest rate at below the federal funds target rate, by analogy to the ECB’s interest
rate corridor. To be able to control the federal funds rate better, the interest rate was increased gradually to the
level of the federal funds target rate, meaning the lower part of the corridor was squeezed to zero. Despite this
measure, the effective federal funds rate slipped below the federal funds target rate at times because some market
participants cannot hold an interest-bearing account with the Fed. Under normal conditions, banks would close
this gap by arbitraging, that is, by borrowing cheap on the federal fund market and depositing the funds with the
Fed and receiving higher interest. Such operations, however, require a functioning money market.
24 The U.K. is, once again, a special case on account of the reserve targets bank set themselves. When the crisis became more acute in October 2008, banks boosted their reserves and thus reduced excess liquidity, though only to
a minimal degree.
70
Monetary Policy & the Economy Q1/09
Monetary Policy Implementation during the Crisis in 2007 to 2008
Chart 12
Overnight Rates and Policy Rates since July 20081
%
6
5
4
3
2
1
0
July 08
Aug. 08
Sep. 08
ECB main refinancing interest rate
Federal funds target rate
U.K. bank rate
Oct. 08
Nov. 08
Dec. 08
Jan. 09
Feb. 09
Mar. 09
Euro area overnight rate (EONIA)
Effective federal funds rate
U.K. overnight rate (SONIA)
Source: Thomson Reuters, NCBs.
1
Since the interest rate cut in December 2008, the Fed has targeted a federal funds rate of between 0% and 0.25%. For the sake of simplicity, this
corridor is represented by a uniform line at the 0.25% level.
But the gap between market and official rates was not very large and simply
foreshadowed the stepwise cut in key
rates a bit (chart 12).
3.3 Did These Measures Represent
Quantitative Easing?
Was the expansion of central banks’
balance sheets tantamount to monetary
policy easing? As stated above, the volume of central banks’ balance sheets
does not in itself indicate whether
monetary policy is restrictive or expansionary. Central bank’s interest rates,
not the size of their balance sheets,
reflect the monetary policy stance. A
specific key interest rate is compatible
with many different balance sheet compositions – a balance sheet may be large
or small, and may contain fewer or
more risky investments.
Hence, observers need to distinguish between changes in central banks’
policy and changes in the composition
and size of their balance sheets since
summer 2007. This distinction is the
basis for the separation principle that
the ECB has repeatedly cited in its public statements. According to this principle, monetary policy decisions and
decisions about key interest rates are
independent of the implementation of
these decisions, which impact e.g. on
the size and composition of the balance
sheet (ECB, 2008c). In practice, this
means that the ECB can support liquidity and the functioning of key financial
markets by adjusting its operational
framework for implementing monetary
policy – without changing the monetary policy stance. In actual fact, the
monetary policy course of the major
central banks developed differently in
the first year of the crisis, in each case
reflecting the economic circumstances
and the mandate of the respective central bank. The Fed, for instance, cut
rates already in September 2007; the
BoE followed in December 2007, but
kept rates above those of the euro area
until November 2008. The fairly positive development of the economy until
the summer of 2008 and concern about
a persistent rise in inflation prompted
the ECB to raise key interest rates marginally in July 2008. The SNB and
Sveriges Riksbank also increased official rates in the year between summer
2007 and summer 2008. Even though
the stance of monetary policy in the
Monetary Policy & the Economy Q1/09
71
Monetary Policy Implementation during the Crisis in 2007 to 2008
various monetary areas differed, the
central banks pursued very similar targets in supporting money, foreign exchange and other markets: Monetary
policy and liquidity policy are two
horses of a different color.25
The central banks’ measures of
October 2008 are best viewed from the
financial stability perspective. As expected in a moment of crisis, the central banks fulfilled their traditional role
of ensuring the supply of liquidity to
the banking and financial system.26
The Lehman Brothers bankruptcy
increased the demand for liquid investments; the expansion of the central
bank’s balance sheet and the respective
asset-side adjustments gave the private
sector a chance to exchange less liquid
assets for perfectly liquid ones, i.e. central bank liquidity (central bank balances). Unlike in the first year of the
crisis, during this stage, liquidity measures and adjustments of the monetary
policy stance developed in parallel. All
major central banks slashed key interest
rates in response to forecasts of declining inflation rates and the sharp slowdown in real economic activity. Monetary and liquidity policy were not
independent of one another, as the
worsening of the financial crisis spurred
new liquidity measures and was also
the cause of the economic slowdown
and hence of the expansionary monetary policy. Nevertheless, the two policies did not have to move in parallel
throughout this phase either. The enlargement of central bank balance
sheets occurred largely during September and October 2008, whereas the
interest rate cuts were taken in November 2008 and afterwards. And even
though monetary policy was gradually
Chart 13
Total Assets of the Eurosystem and of the Fed
EUR and USD billion
2,500
2,000
1,500
1,000
500
0
Jan. 07
Apr. 07
Eurosystem
July 07
Oct. 07
Jan. 08
Apr. 08
July 08
Oct. 08
Jan. 09
Fed
Source: ECB, Fed.
25 Of course, monetary policy and liquidity policy are not independent of one another. Stable conditions in financial
markets are necessary for a reliable and predictable transmission of monetary policy measures to the real economy.
High and volatile risk premiums like those that have been observed in unsecured longer-term money markets
change transmission. All liquidity measures were geared toward reestablishing the normal performance of the
financial markets that are relevant for the monetary policy transmission mechanism. In this sense, liquidity policy
serves the implementation of monetary policy. Crespo Cuaresma and Gnan (2008), however, list some problems
that might crop up in times of crisis, when monetary policy instruments and the provision of liquidity to banks are
changed very massively. Under such conditions, it becomes difficult to achieve a macroeconomically suitable
monetary policy orientation, and it becomes hard to properly communicate the monetary policy stance. While
there are of course manifold links between the monetary policy stance and its implementation, it is useful and
appropriate to consider decisions about the monetary policy stance and liquidity policy measures taken to implement them as separate.
26 For more on the provision of liquidity during times of crisis and potential interaction of central banks’ crisis
intervention role and the implementation of monetary policy, see Crespo Cuaresma and Gnan (2008).
72
Monetary Policy & the Economy Q1/09
Monetary Policy Implementation during the Crisis in 2007 to 2008
eased, the size of central bank balance
sheets, admittedly a very rough measure of liquidity policy, remained
stable and in fact in January 2009 (Fed)
and February 2009 (Eurosystem) shrank
to levels well below those observed in
October and November 2008 (chart 13).
4 Key Policy Rates Close to Zero
and Nonstandard Measures – An Outlook
The decisive interest rate measures of
the past few months have lowered official rates to a level that potentially creates new challenges for the operation of
monetary policy as a result of the zero
lower bound on nominal interest rates.
As cash offers a risk-free nominal interest rate of zero, nobody is willing to invest money at negative interest rates
(which would be equivalent to having
to pay a fee for a deposit). If the central
bank cuts the key interest rate to zero,
it loses its traditional instrument to
stimulate the economy, namely a (further) reduction of the short-term nominal interest rate (Svensson, 2003).
Under such conditions, the central
bank’s operational framework, which is
geared toward managing the shortterm interest rate – the issue discussed
so far in this contribution – is rendered
insufficient. However, the short-term
interest rate is not the only lever with
which central banks can influence the
real economy. They may also resort to
what the public debate refers to as nonstandard measures. All major central
banks – the Fed, the BoE, the Bank of
Japan (BoJ) and die ECB – have either
taken nonstandard measures since the
beginning of the crisis, or have at least
not discounted their use. Little experience had as yet been made with such
measures when this contribution was
written at the end of February 2009, so
presenting and evaluating them must
wait until a later date. To facilitate the
understanding and interpretation of
current developments, this study provides an overview of fundamental considerations and possible measures by
way of conclusion (Clouse et al., 2003;
Yates, 2002).
Reaching the zero lower bound
does not mean that monetary policy
cannot be loosened further. Central
banks’ leverage results from the fact
that the interest rates relevant for economic decisions are not short-term
nominal interest rates, but rather longterm real interest rates, i.e. retail interest rates adjusted for expected inflation. The short-term nominal interest
rate is an important, albeit not the only
determinant of real interest rates. As
investment values are assessed over a
longer period, expectations about future
short-term nominal rates play an important role. Principally, central banks
can influence all these components.
Two historical developments have
produced a fairly recent, comprehensive literature on the issue of monetary
policymaking at the zero lower bound.
When inflation receded in the 1990s
and 2000s, nominal interest rates also
decreased. At the same time, the monetary policy discussion was oriented
more on the inflation rate, and many
central banks were obligated to reach a
specific inflation target. When inflation targets were set, policymakers had
to weigh the disadvantages of inflation
against wage and price rigidities, which
make adjustment to shocks increasingly
harder at very low inflation rates. The
zero lower bound represents one such
rigidity. This literature makes mainly
theoretical arguments and operates
with simulations (e.g. ECB, 2003).
Roughly at the same time, Japan, which
slipped into deflation in 1998, became
a textbook example of monetary policy
at the zero lower bound (Baba et al.,
2005; Ito, 2006). In historical terms,
Monetary Policy & the Economy Q1/09
73
Monetary Policy Implementation during the Crisis in 2007 to 2008
Japan is a big exception, as periods with
nominal interest rates of close to zero
are very rare (Borio and Filardo, 2004).
Both the theoretical literature on
the optimum inflation rate and advice
derived from Japan’s experience apply
to the current situation only to a limited extent. The core scenario in both
cases is deflation, which keeps the real
interest rate too high. But deflation
does not appear to represent the main
problem of monetary policy now. The
decline in inflation worldwide is the
result of the drop in energy prices; inflation is expected to be consistently
above zero in the next few years.
Accordingly, the Fed, which is generally considered to have taken the
most unconventional of measures, underlines the differences between its
case and that of Japan, both in diagnosing the issues and in policymaking. Especially at the beginning, the BoJ chose
to influence the longer-term risk-free
interest rate, first by committing to
continued low short-term interest rates
(zero interest rate policy – ZIRP) and
later by systematically expanding commercial banks’ central bank balances
(quantitative easing). The Fed is now
focusing less on the longer-term riskfree interest rate and more on risk premiums in specific market segments
(commercial paper, money market
funds, student loans, mortgage loans,
etc.). Ben Bernanke, the chairman of
Board of Governors of the Federal Re-
serve System, summarizes the different
approaches under the term credit easing (qualitative easing) versus quantitative easing.27 With its announcement of
March 18, 2009, that it will purchase
longer-term Treasury securities, the
Fed has expanded its strategy and is
now trying to influence both the riskfree interest rate and risk premiums.
The BoE announced a similar policy
move on March 5, 2009.
As credit easing is targeted at
spreads, central banks can use this approach also for key interest rates above
the zero mark if they believe that the
objectives of monetary policy, such as
price stability or full employment, can
be attained better with methods other
than interest rate cuts. In fact, the Fed,
as well as other central banks, e.g. the
BoE and the ECB, started to take measures to influence specific risk premiums long before they began to lower interest rates to the current level. As described above, in the case of the euro
area, the ECB took such measures primarily to influence longer-term money
markets by widening the longer-term
tender operations and full allotment on
the weekly main refinancing procedure
since October 2008. Moreover, the enlargement of the list of eligible securities at the end of October 2008 indirectly supported financial market segments suffering from illiquidity, in
addition to giving banks a bigger liquidity buffer.28
27 See Chairman Bernanke’s speech at the National Press Club Luncheon, Washington D.C., on February 18, 2009
(http://www.federalreserve.gov/newsevents/speech/bernanke20090218a.htm).
28 ECB President Trichet noted, for instance, in the press conference held February 5, 2009, when asked about the
options for quantitative easing in the euro area: “[…] let me remind all of us that when we started to cope with
the tensions on the markets in general – and it is already some time ago, in August 2007 – we were the central
bank in the world that was the most open to eligibility of collateral in the form of private paper. And you know
that other major central banks had to considerably change their own frameworks in order to be able to do more or
less the same. [Our openness to such paper is] something which would have been described in other environments
and other economies as close to non-standard easing. Or close to, I would say, credit easing perhaps, as you know
is the term used on the other side of the Atlantic. And I would again mention the fact that we have to day the
combination of, first, our unlimited supply of liquidity; second, very broad eligibility of collateral; and third, the
fact that our balance sheet has considerably augmented in size.”
74
Monetary Policy & the Economy Q1/09
Monetary Policy Implementation during the Crisis in 2007 to 2008
Which instruments central banks
choose in the future, and how similar
or different their approaches will be,
will depend on many factors. But most
certainly, all measures are preceded by
economic analysis in the different monetary areas. Even if the analysis results
are similar, the measures may differ,
depending on individual central banks’
options as given by their operational
and legal frameworks. Coordination
and the division of responsibilities with
other economic policymakers will be
just as important, in particular with
fiscal policymakers and financial supervisors, who are also subject to frameworks specific to their monetary areas.
References for Central Bank Balance Sheets
Eurosystem: For data on daily liquidity conditions (open market operations, marginal lending facilities) in the euro area (http://www.ecb.de/stats/monetary/res/
html/index.en.html).
The consolidated weekly financial statement of the Eurosystem is retrievable from
the ECB’s Statistical Data Warehouse under http://sdw.ecb.europa.eu/browse.
do?node=2018802
Fed: Weekly historical averages tables:
http://www.federalreserve.gov/releases/h41/hist/
The Bank of England also has an interactive database.
Under http://www.bankofengland.co.uk/mfsd/iadb/BankStats.asp?Travel=NIx,
the consolidated balance sheet of the BoE is to be found under “B Monetary financial institutions’ balance sheets, income and expenditure/Central bank’s balance
sheet (Bank of England ‘Bank return’)/Consolidated statement”
References
Armantier, O., S. Krieger and J. McAndrews. 2008. The Federal Reserve’s Term Auction
Facility. In: Current Issues in Economics and Finance 14(5). Federal Reserve Bank of New York.
July. 73–86.
Baba, N., S. Nishioka, N. Oda, M. Shirakawa, K. Ueda and H. Ugai. 2005. Japan’s
Deflation, Problems in the Financial System and Monetary Policy. BIS Working Paper 188.
Baba, N., F. Packer and T. Nagano. 2008. The Spillover of Money Market Turbulence to FX
Swap and Cross-Currency Swap Markets. In: BIS Quarterly Review. March. 73–86.
Bank of England. 2008. The Development of the Bank of England’s Market Operations.
London.
Bindseil, U. 2004. Monetary Policy Implementation. Theory-Past-Present. Oxford: Oxford
University Press.
Bindseil, U. 2009. Central Bank Financial Crisis Management from a Risk Management Perspective. In: Bindseil et al. (eds.). Risk Management for Central Banks and Other Public Investors.
Cambridge: Cambridge University Press. 394–439.
BIS. 2007. Quarterly Review. September.
BIS. 2008. Quarterly Review. December.
Borio, C. 1997. The Implementation of Monetary Policy in Industrial Countries: A Survey. BIS
Economic Paper 47.
Borio, C. 2001. A Hundred Ways to Skin a Cat: Comparing Monetary Policy Operating Procedures in the United States, Japan and the Euro Area. BIS Paper 9. 1–22.
Borio, C. 2007. Change and Constancy in the Financial System: Implications for Financial
Distress and Policy. BIS Working Paper 237.
Monetary Policy & the Economy Q1/09
75
Monetary Policy Implementation during the Crisis in 2007 to 2008
Borio, C. 2008. The Financial Turmoil of 2007–?: a Preliminary Assessment and Some Policy
Considerations. BIS Working Paper 251.
Borio, C. and A. Filardo. 2004. Back to the Future? Assessing the Deflation Record. BIS
Working Paper 152.
Borio, C. and W. Nelson. 2008. Monetary Operations and the Financial Turmoil. In: BIS
Quarterly Review. March. 31–46.
Chailloux, A., S. Gray and R. McCaughrin. 2008a. Central Bank Response to the 2007–08
Financial Market Turbulence: Experiences and Lessons Drawn. IMF Working Paper 08/210.
Chailloux, A., S. Gray and R. McCaughrin. 2008b. Central Bank Collateral Frameworks:
Principles and Policies. IMF Working Paper 08/222.
Clews, R. 2005. Implementing Monetary Policy: Reforms to the Bank of England’s Operations in
the Money Market. Bank of England Quarterly Bulletin. Summer. 211–220.
Clouse, J., D. Henderson, A. Orphanides, D. Small and P. Tinsley. 2003. Monetary
Policy when the Nominal Short-Term Interest Rate is Zero. In: Topics in Macroeconomics
3(1).
Committee on the Global Financial System. 2008. Central Bank Operations in Response
to the Financial Turmoil. CGFS Paper 31. July.
Crespo Cuaresma, J. and E. Gnan. 2008. Four Monetary Policy Strategies in Comparison:
How to Deal with Financial Instability? In: Monetary Policy & the Economy Q3/08. Vienna:
OeNB. 65–103.
Disyatat, P. 2008. Monetary Policy Implementation: Misconceptions and their Consequences.
BIS Working Paper 269.
ECB. 2003. Background Studies for the ECB’s Evaluation of its Monetary Policy Strategy. Frankfurt.
ECB. 2004. The Monetary Policy of the ECB. 2nd edition. Frankfurt.
ECB. 2007. The Collateral Frameworks of the Federal Reserve System, the Bank of Japan and
the Eurosystem. In: ECB Monthly Bulletin 2007(10). October. 85–100.
ECB. 2008a. The Implementation of Monetary Policy in the Euro Area: General Documentation on Eurosystem Monetary Policy Instruments and Procedures. Frankfurt.
ECB. 2008b. The Analysis of the Euro Money Market from a Monetary Policy Perspective. In:
ECB Monthly Bulletin 2008(2). February. 65–80.
ECB. 2008c. The Eurosystem’s Open Market Operations during the Recent Period of Financial
Market Volatility. In: ECB monthly Bulletin 2008(5). May. 89–104.
Fed. 2005. The Federal Reserve System: Purposes and Functions. 9 th edition. Washington D.C.
Federal Reserve Bank of New York. 2008. Domestic Open Market Operations during
2007. A Report Prepared for the Federal Open Market Committee by the Markets Group of
the Federal Reserve Bank of New York.
Federal Reserve Bank of New York. 2009. Domestic Open Market Operations during
2008. A Report Prepared for the Federal Open Market Committee by the Markets Group of
the Federal Reserve Bank of New York.
Fleming, M., W. Hrung and F. Keane 2009. The Term Securities Lending Facility: Origin,
Design, and Effects. In: Current Issues in Economics and Finance. Federal Reserve Bank of
New York. 15(2) February. 1–10.
Freixas, X. und J.-C. Rochet. 1997. Microeconomics of Banking. Cambridge, Massachusetts:
MIT Press.
Freixas, X., C. Giannini, G. Hoggarth and F. Soussa. 2000. Lender of Last Resort: What
Have We Learned Since Bagehot? In: Journal of Financial Services Research 18(1). 63–84.
Goodhart, C. 1988. The Evolution of Central Banks. Cambridge, Massachusetts: MIT Press.
76
Monetary Policy & the Economy Q1/09
Monetary Policy Implementation during the Crisis in 2007 to 2008
IMF. 2008. Stress in Bank Funding Markets and Implications for Monetary Policy. In: Global Financial Stability Report. October. 69–103.
Ito, T. 2006. Japanese Monetary Policy: 1998–2005 and Beyond. In: Monetary Policy in Asia:
Approaches and Implementation. BIS Paper 31. 105–132.
Oesterreichische Nationalbank. 2007. Financial Stability Report 14. Vienna: OeNB. December.
Oesterreichische Nationalbank. 2008. Financial Stability Report 15. Vienna: OeNB. June.
Michaud, F.-L. and C. Upper. 2008. What Drives Interbank Rates? Evidence from the Libor
Panel. In: BIS Quarterly Review. March. 47–58.
Svensson, L. 2003. Escaping from a Liquidity Trap and Deflation: The Foolproof Way and
Others. In: Journal of Economic Perspectives 17(4). Fall. 145–166.
Tucker, P. 2004. Managing the Central Bank’s Balance Sheet: Where Monetary Policy Meets
Financial Stability. Bank of England Quarterly Bulletin. Fall. 359–382.
Yates, T. 2002. Monetary Policy and the Zero Bound to Interest Rates. A Survey. ECB Working
Paper 190. October.
Monetary Policy & the Economy Q1/09
77